Activity Based Costing

1
Activity Based Costing

• By
• Jan Van Deusen
• Larry Inguagiato

2
Outline

• Overhead Cost Discussion
• History behind Activity Based Costing
• Activity Based Costing
• What is it?
• Who does it?
• How is it done?
• What do you do with it?
• Why activities management uses
• Target Costing
• Conclusion
• Questions

3
Traditional Accounting

• This is how manufacturing has traditionally
  tracked costs.

4
Shifting Trends in Accounting

• Traditionally overhead costs have been allocated
  based on labor costs of a product.
• As technology increases labor costs constitute a
  lesser portion of product costs.
• Also modern companies manage highly diversified
  product lines, which makes random assignment of
  overhead a
• PROBLEM

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Overhead Example
Product A consists of 20 components costing 180
and has an assembly time of 2 hrs at a labor cost
of 20. Overhead is applied based on a direct
labor factor of 120 which results in a cost of
44. The total cost of Product A is 244.
Product B consists of 5 components costing 180
and has an assembly time of 2 hrs at a labor cost
of 20. Overhead is applied based on a direct
labor factor of 120 which results in a cost of
44. The total cost of Product B is 244.
Does this sound right????
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Overhead example

• The key to the example is the difference in the
  number of components
• Logically assembling 20 components must have
  more cost associated with it than assembling 5
  components
• The indirect overhead costs of ordering,
  receiving, stocking and issuing the difference in
  components are not accounted for
• This is the problem with traditional accounting

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History behind ABC

• ABC became practiced in the early 1980s but it
  has really become a force in industry in the mid
  to late 1990s
• Most current approaches to ABC are based on
  concepts developed by the Computer Aided
  Manufacturing-International (CAM-I) Project
• Since then ABC plans have been further developed
  and diversified down to mid and small size
  companies

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ABC What is it?

• ABC is the Activity Based Cost accounting
  method.
• ABC focuses on identifying all activities
  associated with making a product or doing a
  process.

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ABC What is it? (cont)

• Activity Cost
• Identifying activities will yield a total cost
  system.

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ABC What is it? (cont)

• ABC has 3 strategic objectives
• Report accurate costs
• Identify costs of activities
• Identify future need for resources

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Who is involved in it?

• Engineers
• Accountants
• Management
• Factory workers
• Shipping personnel
• Sales
• .EVERYONE!

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ABC Terms

• Activity work performed within an
  organization.
• Resource financial input consumed by
  activities.
• Resource Driver any measure of the quantity
  of resources consumed by activities.
• Activity Driver any measure of the frequency
  and intensity imposed by a cost object.
• Cost object any customer, service, process
  that a separate cost measurement is desired.

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ABC Costs
Business Process
Resource Driver
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How is ABC done?

1. Identify activities.
2. Determine how resources are linked
   to activities. (traced, assigned, allocated
   costs)
3. Calculate activity costs.
4. Identify cost objects.
5. Determine how activities are related to cost
   objects.
6. Calculate cost of object costs.

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ABC Cost Example
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Degrees of Implementation

• Tier 1 Direct Costs
• Tier 2 Incremental Costs
• Tier 3 Full Costs

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Tier 1 Direct Costs

• Direct costs obviously associated with product
  including managerial costs.
• Ex personnel payroll, supplies, rental
  equipment.
• Overhead and support costs not included.
• Oriented for small projects or improving a
  process vs focus on price of production or where
  infrastructure is too large to determine overhead
  and support costs accurately.

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Tier 2 Incremental Costs

• Tier 1 costs support costs of organization.
• Incremental costs typically include over 95 of
  the organizational costs.
• More difficult than Tier 1 due to subjective
  distribution of expenses across multiple elements.

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Tier 3 Full Costs

• Tier 3 includes all organizational, managerial,
  direct, support and overhead costs. This is the
  most comprehensive, difficult.
• Least used method.

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What do you do with it?

• Use the collected data to make smarter business
  decisions.

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Why activities management uses

• Activities are actions
• Improve product cost accuracy
• Activities drive cost
• Facilitates evaluation of alternatives
• Encourages continuous improvement
• Activities are easily understood by user level
• Improve decision support

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Target costing

• Key Japanese design technique
• In Japan, cost is responsibility of design
  engineer same as US in the 1920s
• The Japanese treat cost as a symptom, not a
  cause or solution
• Begins with market-based pricing independent of
  cost what the customer can pay

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Target costing

• Japan
• Target cost Market-priced sales Target profit
• Other countries
• Actual cost Planned profit Price
• Conclusion Costs are best managed during
  concept and design phase

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Conclusion

• ABC is an excellent tool for identifying areas
  of concern in your company as well as being
  useful to integrate into management
• It is however just a tool and must be set-up and
  used properly in order to be beneficial

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Questions?
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Bibliography

• Electronic College of Process Innovation,
  Department of Defense at http//www.c3i.osd.mil/bp
  r/bprcd/
• Brimson, James. Activity Accounting. John Wiley
  Sons, Inc., 1991.
• Cokins, Gary. Activity Based Cost Management.
  McGraw-Hill, 1996.
• Cooper, Robin and Slagmulder, Regine. Activity
  Based Budgeting, Part 1. Strategic Finance.
  Montvale, September 2000.

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Bibliography

• Deo, Baldinger S. and Strong, Doug. Cost The
  Ultimate Measure of Productivity. Industrial
  Management. Norcross, May/June 2000.
• Grieco, Peter Pilachowski, Mel. Activity Based
  Costing The Key to World Class Performance. PT
  Publications, Inc, 1995.
• Marcino, George R. Obliterate Traditional
  Budgeting. Financial Executive.
  November/December 2000.
• Yennie, Henry. ABC The New Cost Cutting
  Tool. Behavioral Health Management. Cleveland,
  September/October 1999.